Pre-Bankruptcy Steps to Take to Eliminate Tax Debt in Bankruptcy

Posted on Jul 15, 2012 11:40pm PDT

Income tax returns were due in April, but what if you owe a alot of taxes, maybe for this year and even a previous year or two? Bankruptcy CAN discharge (legally erase) SOME income taxes. How much tax debt you can discharge can depend on what steps you take BEFORE filing your bankruptcy case.

In this blog I introduce five strategies for increasing what you can discharge. But do NOT try to apply these strategies by yourself. The combination of tax law and bankruptcy law is highly technical and full of twists and turns. Not only do you want to get legal advice, you should do so from a bankruptcy attorney experienced in discharging income tax debts. I am just introducing these strategies here so that you are familiar with them when you come in to see me or some other qualified attorney in your area.

The Five Pre-Bankruptcy Strategies

1. Wait the right amount of time before filing:

As you can see from my other blogs, income taxes can usually be discharged after certain time has passed. So pre-bankruptcy tax strategy is based a lot on figuring out when your tax debts would become dischargeable, and then not filing your bankruptcy until all those taxes can be discharged. That's not always possible if there is an urgent need before then to protect yourself from other creditors, or from the aggressive collection efforts of the IRS or the California Franchise Tax Board themselves.

2. Avoid delaying filing your past-due tax returns:

It's understandable if you are concerned about completing income tax returns for those years that you owe taxes and have no means to pay them. But this can really hurt you. You cannot discharge income taxes until 2 years have passed from the date of filing your taxes. You do need to get solid advice about how to deal with the tax authorities during those two years to protect yourself, and to be prepared to file bankruptcy when your taxes become dischargeable. Delaying the filing of your taxes can also result in the taxing authorities filing a tax return on your behalf, which may result in your tax debt being non-dischargeable.

3. Stay current with recent tax obligations before you file bankruptcy:

Because recent income tax debts can't be discharged in a Chapter 7 case, and must be paid in full in a Chapter 13 case, you need to do whatever you can to stay current or pay as much as possible on these ongoing or recent taxes. With the IRS in particular, you are allowed to specify which tax debt any particular tax payment should be applied to. If you don't do so, that payment will likely be applied to the oldest tax year, one that you were likely waiting to be able to discharge. You can save a great deal of money by having any tax payments you make go where it will do you the most good.

4. Do not risk engaging in any possible tax fraud or evasion:

All the timing and other rules for discharging income taxes go out the window if you are found to have engaged in tax fraud or evasion. That usually involves filing fraudulent tax returns, hiding income and such, but if you have any doubt consult with your tax accountant or attorney.

5. Avoid or minimize the tax lien trap:

The filing of a tax lien can turn a lot of pre-bankruptcy tax planning upside down. That's because taxes that would otherwise have been discharged may have to be paid in full or at least in part in a Chapter 13 case, and would likely not be discharged in a Chapter 7. If you cannot stop a tax lien from being recorded, you can try to minimize its effects. How? By avoiding building up equity in your assets. Why? Because the property exemptions which so nicely protect your possessions from the bankruptcy trustee, do not apply to tax liens. So whatever equity you build up in possessions just increases how much you would likely have to pay to the taxing authority.

I have to end by saying it again-do not use these strategies without the detailed advice of a highly knowledgeable bankruptcy attorney. But I do hope that this blog will give you the idea that you do have some control over the situation, and can often increase the amount of taxes you can discharge in your bankruptcy.

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